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It is important to protect one’s portfolio from crashes like 2007-2009 where the major market indices lost more than 50%. Historically, markets have seen long 4-10 years runs of steady Bull market interspersed with shorter 1-2 year Bear markets. Most losses in a bear market come within a short span of few months. An investor playing good defense will look to time an early exit in a crash. When market is sufficiently oversold, short term bounce backs present further opportunity to make gains. An investor who remained invested during stock market crash from October 2007 to February 2009 lost more than 50% of his investment (based on SPY performance ) during that period. Similarly, between September 2000 and September 2002, fully invested investors lost ~40% ( using SPY as a benchmark ). Both bear markets wiped out 3-5 years of preceding year gains. While timing the market is a hard proposition, it is incredibly important to preserve your portfolio from a major whitewash during a crash. “Defense wins Championships” is a famous saying in football but is more aptly relevant for investors that can successfully maneuver through a bear market. NFL teams with good defense minimize points scored against them by opposition; a good portfolio needs strong defensive strategies to protect from bear market onslaught. Further just like strong defense can actually add to score by triggering turnovers, bear market presents opportunities for sizeable gains which if not exploited means missed opportunity cost. For example, investors who were too risk averse and did not participate in the post-crash rally of 2009-2011, lost out on capital appreciation opportunity of 80-90% within that 2-year period. To build a good defensive strategy, an investor needs to understand the market dynamics. The picture below best illustrates the US stock market history of bull-bear markets ( Source: Business Insider ). (click to enlarge) Key takeaways we can derive from the above picture are: The large part of this graph is dominated by long running bull markets, with most runs lasting many years or even more than a decade. During this multi-year period, the market sees steady returns with small intermittent corrections interspersed. Some examples include the bull market in 1990s, 1980s, 1950s and 1940s, all of them lasted 10+ years. Bear markets are relatively short in terms of overall duration (1-2 years), and the losses come at a much faster rate (compared to gains in bull market). For example, 2008 crash lasted 1.3 years and 2002 crash lasted 2.1 years. The longest bear market was in the 1930s and lasted close to 3 years. “Market goes up in an escalator but down in an elevator” is a famous stock market quote that can summarize the overall dynamics. Understanding the wisdom behind these select few words is important for all investors. The picture below shows 1 example of Bull-Bear cycle in SPY adjusted close graph during the 2003-2008 period ( Source: Yahoo Finance data ). Notice the steady increase in SPY for 4+ years (escalator) followed by a dramatic 1-year crash in 2008, wiping out a large part of multi-year gains. Hence the saying, market goes like an escalator and comes down like an elevator. (click to enlarge) Here is another graph that shows SPY monthly returns ( Source: Yahoo Finance data ) during the 2008 crash period. Notice even during the bear market, the bulk of losses (~-46%) came over a short 9-month period from June 2008 to February 2009. Hence the analogy of elevator coming down vertically or fast. (click to enlarge) The above historical perspective presents multiple takeaways that should influence our investing strategy. Given the long runs of Bull market, sitting out of stock market for extended period of time has significant opportunity cost of not participating in Bull rally. If one wants to protect their portfolio in the event of a crash, they need to get out of market early in a crash. However, getting out too early has risks too as it may only be a temporary dip i.e. no crash, market recovers and one has to get back in at a higher price. So timing the market exit is a balancing act between these two scenarios. Exiting out late in a Bear market can double the pain as one will take the losses but not participate in the rally that should be soon to follow. Buy and hold investors who finally give up on stocks after seeing their portfolios trounced for a year or two, have the risk of exiting out at close to bottom of crash. Building a Defensive Strategy: The above takeaways can be formulated to build a variation of Simple Moving Average (SMA) based strategy. For our example, we will use SPY as a representative market index that we play the strategy on. However, the strategy should be verifiable on most indices with varied performance. The SMA gives an overall trend of market direction that is not easily seen with day-to-day variations. So a simple strategy could be to stay long in SPY when SPY is above its say 50-day SMA and sell all holdings when SPY falls below its 50-day SMA. When SPY index is above the SMA, it is pulling the SMA upwards i.e. leading to a positive trend in index. One big drawback of SMA-based strategies is the whipsaw effect. This happens when stock dips below the SMA, we sell the index but then stocks recover, goes above SMA and we get back. Because we are selling at a lower point and then buying back again at a higher price, this leads to a loss. If this happens with large enough frequency, the strategy can lead to sizeable losses and NEGATIVE returns as compared to Buy and Hold. Since history is dominated by large bull runs interspersed with shorter bear runs, it is probably wiser to side on being long for the most part. So we assume that more often than not the market is expected to bounce back after a dip below SMA leading to whipsaw. To reduce the number of times we go out of market and whipsaw, we can use a longer duration SMA. The longer the duration, the less likely the chance of temporary short-term dips breaching SMA and giving a false sell signal. Let’s take 250-day SMA which is equivalent to 1 year in terms of trading days. Further even when SPY touches or breaches the 250-day SMA that is a major support level indicating a high chance of bounce back. So I would propose the sell SPY signal to be even lower, say when SPY has breached more than 2% below 250-day SMA. So let’s assume that we sell SPY when it’s hit more than 2% below 250-day SMA. On top of this, let’s try to take advantage of the fact that once market is sufficiently down, volatility increases and we expect to see several bounce backs from the lows. The bounce back can be temporary though as we don’t know for sure when the actual bottom is or if the bear market is close to end. To take advantage of this short-term bounce backs, we can define a lower point at SMA for market to be oversold. In this zone, we could look to do some bottom fishing by trying to do the reverse, i.e. buy SPY when SPY is below its short-term SMA, say 4-day SMA and sell it as soon as it recovers. So our strategy becomes as follows: Stay long in SPY as long as SPY is greater than -2% (say X) of its 250-day average. Sell and go in cash if it falls below X. If SPY falls below 6% (say Y) of 250-day SMA look to bottom fish. Buy SPY when it is below its 4-day SMA expecting a short term bounce back and sell as soon as it comes back above its 4-day average. These are short-term trades that take advantage of market’s volatility. Now while the thresholds pick (X and Y) may feel like magic numbers, in my test almost all combinations of X and Y where XScalper1 News
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